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Alienation!
DAVID HUGHES BBS, MA (TCD), AITI, ACA, FTII considers the issue of whether a redemption of a non-qualifying corporate bond loan note constitutes an alienation under certain United Kingdom tax treaties.
Alienation!
DAVID HUGHES BBS, MA (TCD), AITI, ACA, FTII considers the issue of whether a redemption of a non-qualifying corporate bond loan note constitutes an alienation under certain United Kingdom tax treaties. ALTHOUGH THE UNITED Kingdom does not in general impose capital gains tax on the disposal of chargeable assets made by non-resident persons, the relevant provisions of tax treaties may still be in point, for example in the case of dual resident individuals claiming non-United Kingdom residence under a treaty tie breaker clause. It is possible, using the capital gains tax article of a suitable tax treaty, to avoid incurring a liability to capital gains tax on the disposal of certain chargeable assets. This article examines various tax implications of relying on the capital gains tax article of a relevant tax treaty in order to avoid a liability to United Kingdom capital gains tax, arising in respect of the redemption of a non-qualifying corporate bond.
Treaty provisions
An extract from the capital gains tax article from the United Kingdom-Switzerland tax treaty, which follows the relevant provisions of the Organisation for Economic Co-operation and Development Model Treaty, is set out below. It is essential to check the wording of the treaty under consideration, as the wording may vary considerably.
Article 13: Capital gains
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13(1) |
Gains derived by a resident of a contracting state from the alienation of immovable property referred to in Article 6 and situated in the other contracting state may be taxed in that other state. |
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13(2) |
Gains from the alienation of movable property forming part of the business property of a permanent establishment ... |
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13(3) |
Gains from the alienation of ships or aircraft … |
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13(4) |
Gains from the alienation of shares of a company, the property of which consists principally of immovable property situated in a contracting state, may be taxed in that state. |
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13(5) |
Gains from the alienation of any property, other than that referred to in paragraphs (1), (2), (3) and (4), shall be taxable only in the contracting state of which the alienator is a resident. |
In order to obtain relief under Article 13, it is therefore necessary that the property being alienated is of a type falling within Article 13(5). Further, it is necessary that an 'alienation' occurs. The term 'alienation' covers a sale. (See the Organisation for Economic Co-operation and Development commentary on Article 13(5) below.) However, there are instances where problems may arise, and these are set out in Examples 1, 2 and 3.
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Example 1 |
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In 1999-2000, Bob Smith, a United Kingdom tax resident, is held to be tax resident in Switzerland under the tie breaker clause of the United Kingdom-Switzerland treaty. In this year, he disposes of shares in his family company. Mr Smith may make a claim under the United Kingdom-Switzerland tax treaty that Article 13(5) applies to remove a liability to United Kingdom capital gains tax. |
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Example 2 |
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The facts are as in Example 1, except that Mr Smith's loan notes (non-qualifying corporate bonds) are redeemed during the tax year. |
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The issue that arises here is whether the redemption of a loan note constitutes an alienation within the meaning of the capital gains tax article of the United Kingdom-Switzerland tax treaty. |
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Example 3 |
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The facts are as in Example 1, except that Mr Smith's loan notes (qualifying corporate bonds) are redeemed during the year. |
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On redemption, any gain that arises on the disposal of a qualifying corporate bond is exempt by virtue of section 115(1), Taxation of Chargeable Gains Act 1992. In addition to the point raised in Example 2, the treaty may not apply to any gain previously held over but crystallised by the sale under section 116(10)(b) ( Bricom Holdings Ltd v Commissioners of Inland Revenue [1997] STC 1179). |
Meaning of 'alienation'
The meaning of the word alienation is not defined either in the United Kingdom-Switzerland tax treaty nor the Organisation for Economic Co-operation and Development Model Treaty. Article 3(2) of the United Kingdom-Switzerland treaty contains the general rule that 'any term not defined shall, unless the context otherwise requires, have the meaning which it has under the law of [the contracting state] concerning the taxes which are the subject of the convention'. However, the term 'alienation' is not one used in United Kingdom domestic law. The Shorter Oxford English Dictionary definition in this context is 'the action of transferring ownership of anything', which is not particularly helpful. The Organisation for Economic Co-operation and Development commentary on Article 13 provides some useful guidance. The ruling in Commissioners of Inland Revenue v Commerzbank [1990] STC 285 provides an authority for referring to the commentary when interpreting a convention between Organisation for Economic Co-operation and Development member countries. In Memec plc v Commissioners of Inland Revenue [1998] STC 754, Mr Justice Robert Walker summarised the Commerzbank principle thus: The Organisation for Economic Co-operation and Development commentary on Article 13(5) states:
'The words "alienation of property" are used to cover in particular capital gains resulting from the sale or exchange of property and also from a partial alienation, the expropriation, the transfer to a company in exchange for stock, the sale of a right, the gift and even the passing of property on death.'
It is clear from the commentary on Article 13(5), that alienation is not to be narrowly defined. Indeed Philip Baker in his book on double taxation conventions notes that 'clearly "alienation" is intended to have a wider scope than "sale or exchange" which had been used in some earlier agreements and had led to problems over deemed dispositions'. Notwithstanding this, it is not entirely clear from the commentary on this paragraph whether the term is intended to encompass the redemption of a loan note, although redemption certainly shares many of the characteristics of an exchange, as under a redemption the rights to receive repayment under the loan note are effectively exchanged for that repayment. The position, however, is further clarified by commentary on Article 13(4) below, which implies that the redemption of bonds or debentures is intended to fall within the relieving provisions of Article 13. By emphasising that the non-capital element of the redemption of a bond may fall under another article of the treaty, it is implied that the capital element must fall within the capital gains article. The commentary reads as follows:
'29. As regards gains from the alienation of any property other than that referred to in paragraphs (1), (2) and (3), paragraph (4) provides that they are taxable only in the state of which the alienator is a resident. This corresponds to the rules laid down in Article 22.
'The article does not contain special rules for gains from the alienation of shares in a company or of securities, bonds, debentures and the like. Such gains are, therefore, taxable only in the state of which the alienator is a resident.
'If shares are sold by a shareholder to the issuing company in connection with the liquidation of such company or the reduction of its paid-up capital, the difference between the selling price and the par value of the shares may be treated in the state of which the company is a resident as a distribution of accumulated profits and not as a capital gain. The article does not prevent the state of residence of the company from taxing such distributions at the rates provided for in Article 10: such taxation is permitted because such difference is covered by the definition of the term "dividends" contained in Article 10(3) and interpreted in paragraph (28) of the commentary related thereto.
'The same interpretation may apply if bonds or debentures are redeemed by the debtor at a price which is higher than the par value or the value at which the bonds or debentures have been issued. In such a case, the difference may represent interest and, therefore, be subjected to a limited tax in the state of source of the interest in accordance with Article 11 (see also paragraphs (20) and (21) of the commentary on Article 11).'
Contrary argument
It has been suggested that, since the satisfaction of a debt is deemed to be a disposal by virtue of section 251(2), Taxation of Chargeable Gains Act 1992, this implies that without such provision a maturation of a loan note would not constitute a disposal, and therefore cannot constitute an alienation within the meaning of a tax treaty. First, it is not clear that the satisfaction of a debt does not constitute a disposal. The provisions of section 251(2) may merely have been included in the capital gains tax legislation to allay the concerns of an overly-cautious draftsman. Secondly, I would argue, however, that in any event, there is no requirement that a disposal occurs, since what is required to afford treaty protection is merely an alienation of property. Death is an example in which the commentary considers that for these purposes an alienation occurs but which otherwise would not normally be considered to be a disposal. Section 62, Taxation of Chargeable Gains Act 1992 appears to underline the fact that death does not constitute a disposal by providing in subsection (1):
'For the purposes of this Act the assets of which a deceased person was competent to dispose -
'(a) shall ...
'(b) shall not be deemed to be disposed of by him on his death ...'
Positive result
It appears clear from consideration of the Organisation for Economic Co-operation and Development commentary on Article 13 of the treaty, that the word alienation is intended to cover the redemption of a bond or security. In the absence of any contrary provision in United Kingdom tax law and noting that the United Kingdom did not make a reservation on this point to the Organisation for Economic Co-operation and Development Model Convention, it is submitted that the redemption of a bond or security is an 'alienation' for the purposes of the application of certain United Kingdom tax treaties. Nevertheless, practitioners may wish to remove the issue entirely by advising clients to dispose of loan notes prior to their maturation. David Hughes is a tax consultant with WJB Chiltern, and can be contacted on tel: 020 7153 2429.
